The Agency Tax Costs of Mutual Funds

Abstract

In the intermediated economy of the twenty-first century, retail mutual fund investors cede investment and voting decisions to institutional investors who manage the funds. As a result, actions undertaken unilaterally by financial intermediaries dictate the tax liability of passive individual investors. This Article argues that the tax decisions of institutional investors are guided by their own tax considerations rather than by the tax considerations of those beneficiaries who own mutual funds through conventional taxable accounts. Because these beneficiaries, unlike the institutional investors, are tax-sensitive, the diverging incentives give rise to agency tax costs.

These agency tax costs arise from the institutional investors’ trading decisions and stewardship activities, as well as their voting behavior. Because these investors regularly vote on corporate mergers and acquisitions (M&A), voting outcomes on these transactions are distorted. The structure of M&A deals, the method of payment used in such deals, and even premiums paid to sellers are skewed because the votes of passive tax-sensitive investors are cast by tax-insensitive institutional investors. As a result, institutional investors not only fail to replicate the tax outcomes that tax-sensitive investors could have achieved had they owned stock directly, but they also fail to achieve the same corporate voting outcomes. This Article proposes several options for mitigating agency tax costs. These options include mandatory separation of funds based on the tax profile of the beneficiaries, heightened tax disclosure by mutual funds, decentralization of votes in mutual fund sponsors and pass-through voting systems. These alternatives would reduce the agency tax costs of mutual funds without imposing new agency costs on tax-insensitive shareholders who also rely on institutional investors for portfolio management.